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Going back to investment basics

Italian forum

The International Investment Italian Forum took place last month in Milan. Here is a summary of the issues examined by the fund managers and economists who addressed the meeting

What could go wrong in 2005? A macroeconomic outlook

Professor Andrea Beltratti

Professor of economics, Bocconi University

If we look at macroeconomic forecasts, the outlook is very positive. Forecast inflation rates across the world vary between 0% and 10%.

"This is a very low inflation scenario for the world as a whole. Growth also varies a lot: between 8% all the way down to the low-growth countries like Italy, Germany, The Netherlands and Japan, where the forecasts are between 1.6% and 1.8%."

There are a number of issues that could cause problems going forward. One of the most obvious is the price of oil. "There is no doubt prices went up mainly because of global economic recovery," said Beltratti. "Although some think that speculation also played a part."

However, Beltratti thinks the risk has been over inflated. If you look at inflation-adjusted oil prices, the current price is half what it was in 1982. So the problem is really that we are not used to oil being reasonably priced.

In any case, where does this current positive outlook come from? "Is the global recovery spontaneous or not?" Beltratti asked. "My answer is that it is not. We have to remember that the current business cycle is being driven by one of the most inflationary monetary policies of all times. It is unusual to find interest rates at such low levels."

He pointed out that real rates in the US were negative - an extremely unusual situation with some potentially damaging effects. "On the one hand it encourages companies to invest in wasteful projects and to over invest in other assets," he said.

But do fiscal policies counteract these forces? "Absolutely not," he said. "In the US, the public deficit this year is going to be big - about the size of the foreign reserves of China - about $400bn."

Spending in the US, especially on healthcare, will increase the total spend from 8% to 15% of GDP by 2030. Japan already has expensive fiscal policies.

A further problem is the lack of saving by investors - there is no aggregate private accumulation of wealth in the US, and in many EU countries the same is true. This in effect pushes demand from the future into the present.

Despite being labelled a growth investor, Hagstrom does not see a clear-cut division between growth and value investing. He thinks many lessons can be learned by looking at the investment processes of Warren Buffet. Hagstrom is an expert on Buffet - he has written three books on the man - and has tried to extract the secrets of Buffet's success.

He said: "The reason why Buffet is the second-richest man in the world, with $44bn net worth, is because he bought a select group of great growth companies at very good valuations. So this is the prime example of a growth investor who understood the valuation of companies and held on to them for a long time.

"Warren would tell you it is not that hard. It is a simple process. He said: 'Your goal as an investor should simply be to purchase at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now. You will only find a few companies that do this, so when you see one that qualifies you should buy a meaningful amount of stock.'

"Basically that is the essence of Warren Buffet," Hagstrom concluded. One of the things Hagstrom's colleague, Bill Miller, has to keep defending himself about is the inclusion of what appear to be growth stocks in his 'value' portfolio.

"Value investing and growth investing are one and the same - growth is part of value, part of the same equation. And, most importantly, returns on incremental capital are the key."

Active Management in a Low Return World: the Role of Company Research

Aled Smith

Head of equity research, M&G International Investments

Aled Smith suggested that the advice fund managers get from 'market experts' - the stockbrokers - is generally wrong.

"We often see advice to buy at the top and, as the stock falls, we are still told to buy," he said. "After the great fall, the stock is fairly valued and continues fairly valued until there is some more bad news. Then, right at the bottom in the panic, we are told to sell. Why does this happen?"

His answer is that human nature leads to these mistakes. Our brains naturally try to find patterns even where there are none.

The three major problems are, firstly, that we assume, often incorrectly, that past performance reflects future performance; secondly, we over-estimate our own abilities; and, finally, we dislike losses more than we like gains. All three lead to consistent misjudging of markets.

So what can people do to beat the bias? "For a start, people should not use stock brokers' predictions. Stock brokers should give up setting price targets - they are not very good at it," Smith said.

The answer, he believes, is to use 'reverse engineering'. Look at the market price and ask what it is implying and then look for the exaggerations often caused by sentiment.

Finally, communicate effectively: analysts must be braver about what they know and don't know - and a boutique philosophy helps to nurture that.

Earnings Do Matter

Will Jump

Chief executive officer, AXA Rosenberg Investment Management (London)

"We believe that earnings matter. That might seem like an odd statement but it was not that long ago that investors on a wholesale basis forgot that earnings mattered and started rewarding companies that, in the end, did not produce earnings to justify their prices.

Why should earnings matter? Jump agrees with Legg Mason's Robert Hagstrom not to treat companies as 'value' or 'growth' but as a relationship between current price and future earnings. The price of a company should represent the present value of the future earnings streams of that company. When a share price is less than that, then it is an attractive stock and vice versa.

To analyse this, Jump took the universe of US stocks and split them into five portfolios, Q1 to Q5, listed in order of five-year future earnings yield divided by their share price at the start of the five years. For every month the process would be repeated, so the stocks would change position in the list according to how their share price varied relative to future earnings yield."

"Even though we did not set out to identify value companies or growth companies - just those who created the best future earnings - we found that on a trailing basis, those with the highest earnings to price, or lower P/E, created the most value."

If you look at the performance of the stock price of those companies, there is a correlation between those that produced the highest earnings and those whose shares did the best. So it would seem that the market does take account of earnings.

On average the relationship is strong. There are two areas in recent history where the relationship broke down: the first is during the technology bubble; the second is 2002-03, although there is less data for that period. Axa Rosenberg went through the same process again, this time looking at earnings growth and a similar correlation was found.

If you were to take the companies that in the last five years had had strong earnings growth, however, then there is no reward and in fact there is a slight bias against them. "So identifying those companies with the best five-year future earnings is very tough," Jump concluded.

Alternatives to government bonds

Stephen Lee

Fixed income fund manager, Morley Fund Management

Stephen Lee provided an overview of all the various fixed income classes outside traditional government bonds - high-yield, corporate bonds and emerging market bonds - and claimed that a combination of all those asset classes actively managed could lead to an optimal portfolio.

"We started with investing in eurozone government bonds. We added to that US government bonds, with the currency exposure hedged back into euros. Then some European corporate bonds, emerging market debt and eurozone high yield."

The result of Lee's analysis showed that the best risk/return mix used all of the asset classes. "If you invested e100 in 1998 in eurozone government bonds, you would get e132.2. You get a slightly better performance by investing in US government bonds. Eurozone corporates were somewhere in the middle of the two, and high yield was the worst performer - there were a lot of defaults, but still a creditable return. The best performer was the emerging markets sector, which would have returned e212 over the last six years.

"Over the last three years, the return has been very different - emerging markets underperform high yield. With active management, the timing effect of when you go into these asset classes has a material impact on the portfolio."

The current default rates in investment grade are 0%. In high yield, they are 2.3% of the index and in emerging markets 2%. In terms of recovery rate, emerging market and high yield are similar - about 30c-40c on the dollar.

Investment grade has a strong correlation to government bonds but emerging market and high yield have very low correlations, and so provide an opportunity to diversify an investor's sources of return.

Asset-Backed Securities (ABS)

Mark Hannam

Managing director, Barclays Global Investors

"One of the most interesting things is that we have seen increasing use of asset-backed securities (ABS) over the last few years, particularly amongst the more sophisticated fixed income investors. At a time when interest rates are likely to rise, this looks to be an asset type that allows investors to increase the yield on their portfolio without extending the duration of their portfolio."

ABSs come in two types - the fixed rate or floating rate - but as both increase yield over the same duration, they reduce exposure to market fluctuations in times of rising interest rates. In addition, the volatility of the spreads are typically much lower than other fixed income instruments, such as corporate bonds. So owning ABS also reduces spread risk. Finally, because of the particular legal structure, it reduces the default risk because the investor has a legal claim on the underlying assets.

The structure that most ABS deals take is the sale or movement of a set of assets and the cashflows attached to them into a trust or vehicle, and the trust in turn issues the debt which is bought in the capital markets by the investors.

In many ways, ABSs are similar to corporate bonds - there are cashflows and there are interest payments that are your coupons. You are paid your capital back on maturity. But difference is the claim the investor has on the underlying assets.

For example, consider securitisation of residential mortgages: the bank sells the payments from the owners of the houses into the capital markets and the investor is entitled to the payments on the mortgages that come in. If there is any problem with the deal - if the owners of the houses do not pay their mortgages - the owner of the ABS will have title over the property. This makes these assets particularly interesting because they provide investors with additional protection.

The basic research methodology for both long-only and hedge managers should be similar: a quantitative screen, qualitative analysis and then ongoing quantitative monitoring.

"However, it is difficult to provide a thorough quantitative analysis for many hedge funds," said Forsyth. "They tend to be skills-based strategies, with 80% of the returns coming from the manager, and 20% from the market."

Forsyth also mentioned additional issues such as transparency, the outperformance of start-ups and the problem that most of the best funds with long track records are closed to new investments, which means even if there are good funds available, many will have short track records.

There are six main areas that Forsyth Partners examines when selecting managers for its funds, and these are the criteria that every hedge fund investor should be aware of.

They are:

• Philosophy: the fund manager should have a practical, intuitive and clearly defined investment s style, reflected in the portfolio.

• Process: the manager's research function should be high quality and shown to be sustainable, as should its security selection process, portfolio construction or fund reporting. The last two tend to be particularly problematic for hedge fund managers.

• People: the staff in any fund are vital to its success. They must be of high quality, have the appropriate experience, and be likely to stay with the fund in the future. This is for all staff, whether the portfolio manager, analysts or support staff.

• Performance: consistency of returns must be matched with volatility targets, market outlook and portfolio positioning.

• Risk: this is a classic problem with small-scale hedge funds - the lack of risk controls and methodology, lack of monitoring and lack of transparency all point to potential disaster areas in the years ahead.

• Resources: the company ownership, structure and remuneration can be a vital factor that allows good funds to fail, especially in the hedge funds world.

Ethical investment means different things to different people

Alex Illingworth, fund manager,

Insight

There are two important points. Firstly, ethical investment is taking ethical considerations into account in a financial decision. Secondly, it is using the rights associated with share ownership in a responsible manner.

"With the legislative and regulatory framework under which we labour, it is increasingly important not to ignore this particular area," Illingworth said. "And there are strengthening links between ethical investment and financial return.

"How can these companies outperform? Well, there is an argument for increased efficiency. If you, as a management team of a company, have a good human rights policy, you have a happy workforce and are more likely to have an efficient workplace.

However, aside from the hope that ethical policies could push a company towards good management, it is possible that there could be benefits but in the opposite direction - avoiding the negative effects. In an world in which governments are becoming more inclined to introducing paternalistic legislation to protect the working conditions and lives of people, and in which consumers increasingly take responsibility for the products they use, companies must keep a constant eye out from the various forms of downside risk.

The first is reputational risk. This has particular impact on global retail brands. The best and most famouse example is that of Nike, which suffered a great deal of economic harm when its name was linked to sweatshops in the Far East. This is a result of global news coverage and more consumer activism than before.

"In regards to litigation risk, says Illingworth, "the most obvious example is tobacco. If you invest in a tobacco company, you need to take into account these issues - take on board the corporate governance and ethical policies that the companies have in place.

"For regulatory risk, a prominent issue at the moment is the development of regulation of chemicals throughout the European Union. It is shifting the burden of proof onto the chemical companies to prove that all the chemicals that have ever been synthesised are now free of any environment. This brings with it significant extra cost to the chemical industry.

"Finally, a good example of fiscal risk is the recent creation of a carbon tax."

Brand is a hugely important part of the value of a company, according to Illingworth. The ethics of a company directly effect its brand, so one with a poor ethical policy will find it more difficult to be able to build its brand and take it into new markets.

Investing in the 21st Century - A Changing Scene

Ewen Cameron Watt

Head of strategic investment group, Merrill Lynch Investment Managers

According to Ewen Cameron Watt, over the last 50 years there has been a long period where equities outperformed bonds. Since 1980 falling interest rates and inflation meant you had a bull market in both equities and bonds. Behind that has been a long decline in macroeconomic volatility. Now we have reached a point where the valuation on equities and bonds means the level of long-term returns from today will be lower than in the 1980s, 1990s or, in fact, since 1950. Because of that lower rate of return, a lot of the solutions proposed based on the past are going to be wrong because they are basing their assumptions on something that is not going to happen again.

Cameron Watt used the US as an example. He showed that as macroeconomic volatility has fallen, dividend yield on US equities has gone down - in other words the price has gone up.

"When you reached a situation a couple of years ago where macroeconomic volatility had all but disappeared, it was not possible for it to go down a great deal further. And so it started to rise and the dividend yield has begun to rise, which is why the US market has not been good over the last three or four years."

Cameron Watt feels that from here it is either going to go sideways - or worse. For the past 20 years, the equity markets have been good. You could have made most of the money from the stock markets in the 20th century in the last 20 years. After such a high period of returns, it is unlikely you will get the same into the future.

Looking at bond yields, Cameron Watt noted that, since 1800, the nominal bond yield on long-dated dollar treasuries has never been lower except in periods of economic depression. "So if you want to buy bonds today - if you think that the return you will get from bonds are going to be reasonable at all, you believe in deflation. That is what you believe in when you buy investment-grade bonds today. If you don't believe in those, you are buying an expensive asset - you are behaving stupidly."

Corporate bonds are not a solution because they behave exactly like government bonds. Neither is high yield, because although it is uncorrelated to government and corporate bonds, it is correlated to equities. It is not a magical diversifier, you are just buying equity risk instead.

What about hedge funds? "There is also a problem here: you are not the first person to think of that," said Cameron Watt. "And the consequence is that the returns over cash for investing in hedge funds are getting lower, even before this year's poor performance."

The future of the hedge fund industry is based on the somewhat shaky idea that investors will be prepared to continue to pay high fees for what looks to be close to cash performance.

Is it Time to Redefine the Traditional Concept of Risk?

Kim Asger Olsen

Managing director, head of investments, Nordea Investment Funds

According to Kim Asger Olsen, the way that risk is talked about and acted on in the world of investments in general is fundamentally flawed. In his previous career, he acted as a sort of freewheeling economist who would be brought in to talk to private banking clients.

At one such meeting in 1994, he remembers that his company at the time had some investment funds that had performed well relative to its benchmark. However, the benchmark had not performed well.

"The investment funds had outperformed 2% in a falling market which was definitely good. We would happily tell our private banking clients 'Yes, the market fell 10% but you lost only 8%'. And the client would say 'What idiots you are. Why did you invest if he could see the market was falling?'"

Now imagine a different meeting between a fund manager and a pension fund representative for a group of people who are perfectly aware of what alpha, beta, gamma and so on mean in financial terms. These two guys would look at exactly the same situation and agree that the fund manager did a brilliant job. They would have a good lunch, paid for by the pension savers and they would agree that everything is good.

"We have two completely different ways of looking at the market. The private investor was allowed to haul the fund manager up on his actions but the smaller investor still has to live with the economic reality of what happened. Many members of the investment community sing the same song - and it is one that I have grown increasingly critical of."

Olsen pointed out that everyone in the investment community are all taught that the hero of all things risk-related is Markowitz and his efficient market theory. "But I believe that this way of thinking is only fit for losers. It is a way of thinking that is irrelevant to the people putting money into our investment products."

Markowitz tells us that risk is defined as deviation from expected market return, so to do a classic 'cover my back' manoeuvre, you must do what everyone else is doing. The investment community is effectively encouraged to invest in index stocks - to do anything else is regarded as 'risky'.

"If you look at it, it makes no sense" he said. "The question 'Should you be investing at all?' is not being asked."

Limiting Risk in Concentrated Portfolios

Andrew Arbuthnott

Portfolio manager, Pioneer Investments

In a low-return environment, investors are looking for different ways to add value to their portfolios. There are various well-known options: hedge funds, commodities and so on.

"But when it comes to equities, we think one of the ways to add value is through a concentrated equity strategy," Arbuthnott said.

He has identified three primary advantages to concentrating a portfolio. Firstly, the approach maximises the productivity of the investment process.

Secondly, the strongest investment ideas do not get diluted by the presence of hundreds of other holdings the investor does not necessarily have a lot of conviction in - they just happen to be in the benchmark.

Thirdly, if it is effectively executed, a concentrated approach can add a great deal of value relative to the benchmark.

"I would also add a fourth point - a more unofficial one. It is more enjoyable for the fund manager to have a concentrated portfolio," Arbuthnott said

But there are also risks associated with the technique, which Arbuthnott has divided into three. The first one is that the impact of stock-specific events on a portfolio is exacerbated. The second is that the performance of the fund can be compromised by short-term fluctuations. Finally, greater concentration can lead to higher volatility.